Sunday, January 28, 2007

Towards a Service Oriented Software Industry

byFrancois Nadeau

Abstract:This report predicts that the software industry will not be able to continue using a Product Oriented business model, and will be forced towards business models which are Service Oriented. It concludes that although the Product Oriented business model for the software industry will still be lucrative, this model will not be sustainable in the long term, and the opportunities for applying it will diminish as the software industry matures.

Introduction

This report is a prediction that business models followed by software companies will become predominantly service oriented.

Current business models used by software companies can be grouped into three categories; Product Oriented (PO), Service Oriented (SO), and Hybrid Oriented (HO)[1].

Companies which follow the PO business model generate most of their income by selling software licenses. Licenses involve a one­time payment from the client for a packaged software solution. This model is based on the one used by companies which sell physical objects such as televisions, cars, and radios. A good example of a software PO company is Microsoft with its Windows Operating system[1].

SO companies generate income by selling software services. These companies create, integrate, upgrade, or manage software for a client. Typically SO companies create unique solutions for their clients for specific needs, and normally these solutions cannot be packaged and sold "as is" to another client[1]. PriceWaterhouseCoopers is a good example of an SO company since most of its revenues are derived by services such as IT services, outsourcing, and consulting[2].

HO companies generate their income from both products and services. Many PO companies become HO over time. For example, in 1993, 80% of Business Objects revenues were derived form its products versus 55% in 2002[1]. The rest of the revenues for Business Objects came from services. That is, although Business Objects was a PO company in 1993, it had become an HO company by 2002.

I believe that as the software industry matures, companies will no longer be able to use a PO model. The discussion section of this report elaborates on the reasoning behind such a prediction.

Background

Up to the 1980s, software was considered a public property. Software developers freely shared their code with each other in the same manner that academic research is shared in the public domain. However, in the 1980s, commercial companies started hiring programmers to create commercial proprietary software, and this caused a change in attitude[3].

In the beginning, the business community believed that software was a magical product. The inexpensive cost of reproducing software caused this belief, since large Return On Investment (ROI) could be acquired by selling multiple copies of the same software product. However, cheap reproduction cost also created a large problem, since customers could also reproduce the software very easily[3].

Nevertheless, the software industry became awash with companies selling copies of prepackaged software. This created fierce competition between the software providers, and forced them to both invest in enhancement for their products, and lower their prices. At the same time, the computer user base increased drastically due to the introduction of Personal Computers (PC). Due to these market factors, the software industry has separated into two communities: platform leaders and platform complementers. Platform leaders are the base system onto which platform complementers create their products[4]. For example, Norton's Anti­Virus is a complementer for the Microsoft's Windows platform.

During this time of computer use expansion, the software industry had to struggle with "software piracy". This term refers to the use of commercial software without payment of the licensing fees. For example, it was estimated that in 2003, companies in the United States were deprived of 6.5 billion USD due to unpaid licensing fees[5].

The increased use of the Internet has greatly eroded the capability of PO companies to protect their products from being illegally copied. The Internet has done this by providing a medium from which software can be copied more easily then previously. Before the Internet, software had to be physically transferred by disk or other external devices, which greatly limited the radius of exposure.

Although most of the media focus for the past twenty years has been on the innovative contributions from the private sector, the public sector has also made great contributions to the software industry. One of the most famous public sector contributions is the Open Source movement. For example, this report was created with an Open Source software named OpenOffice which is a freely available office tool. I did not have to pay any license fees for using it.

Discussion

The research for this report was done by examining the Appendix section of Michael Cusumano's book The Business of Software, and by searching for historical events, examples, and definitions from the Internet. Although the cited book does not contain the prediction stated in this report, its author does describe changes in the business models used by large software companies in the past twenty years.

The PO business model used by software companies is the same model used by companies which sell physical objects. This model functions well when selling physical objects, since these products have a reproduction cost. For example, an individual can copy the design and functionality of a toaster, and consequently construct their own instead of buying one. However, most persons would purchase this item, since the cost of the labor and material required to reproduce it is greater then the cost of the object at the store.

Unlike physical objects, software does not cost anything to reproduce. That is, software companies which pursue a PO business strategy do not incur any cost for software reproduction. This creates an imbalance in the traditional PO system, and companies which use this model need to take measures to protect their interests. Some of these measures include the creation and enforcement of copyrights and Intellectual Property (IP) laws[6].

Copyright laws are legal restrictions placed on products. Their purpose is to protect materials which do not have a great reproduction cost from being imported, exported, modified, displayed, or sold without the originators' authorization. In most cases, it is the responsibility of the copyright holder to protect himself against violations[7].

The legal term IP refers to rights granted to an individual to exclusively exploit an original idea. These laws treat intellectual work in the same manner as physical property. That is, just as a person can claim exclusive rights to property such as farm land, a person can also claim exclusive rights to ideas. Internationally, IP rights are protected by trade agreements between countries, and are championed by institutions such as the World Trade Organisation (WTO)[8].

Another measure used by software producers is to cripple the software product so that the end­ user must either complete an online registration, enter a software license number, or use hardware modifications to be able to use the software. For example, AutoCAD's license lock is a small device which must be connected to the parallel or USB port in order to enable use of the software[9].

Many PO companies such as Microsoft claim that the software industry could not function without these artificial mechanisms[10]. However, these mechanisms cost a great deal to use. For example, the cost of policing their user­base to make sure that all licenses are paid for, legal costs such as lawyers for suing unlicensed users, and development costs for code which impairs non­paying customer from using the software. Although no added value for the end­users is generated by the use of these mechanisms, the cost of these measures is included in the license price paid by the end­ users.

Software PO companies claim that the cost of software development can only be fully recovered from software sales. Although there is no proof for this claim, it has often been used to defend the PO model. Interestingly, there exist companies, such as MySQL, which do not charge any fees for the use of their software.

MySQL commercial products are exclusively funded by revenues from support, training, certification, consulting, commercial licensing, and partnering. This means that MySQL's flagship product, the MySQL database, can be used by most people without paying any licensing fees[11]. Users are only required to purchases a licence if they want to modify the database source code without releasing the modifications under the GPL license. MySQL does not currently have as many features as Oracle, the current database leader, but many of Oracle's customers are switching to MySQL to avoid licensing fees[12].

Support for the PO model can be found with people who believe that IP laws are required to create innovative technologies[10]. This belief is based on the assumption that inventors only share their discoveries if they stand to gain financially. By applying the behavioristic conditioning theory, it is possible to shown that the same result could be reached if inventors valued social recognition more than material gains. However, a full discussion of such an argument is not within the scope of this report.

Another aspect of the protection of software licenses can be seen when comparing third-­world countries with developed countries. The majority of software companies which use the PO business model are found in developed countries. This can be explained by the fact that developed countries have had exclusive access to the technology required to make and use software. As software becomes a requirement for countries entering the global economy, some countries are attacking the PO model. For example, the Peruvian government recently passed a legal bill requiring all state departments to use open source software exclusively[13]. The successful passing of this bill means that only companies following an SO business model can supply software to the government of Peru.

Conclusions

Although some companies which follow a PO business model are trying to keep this model viable, I believe that it is not possible for the software industry to maintain this model. My belief is based on the costs of maintaining the PO system functional, and the fact that the software niches are decreasing as the software industry is maturing. I believe that the PO business model functioned for the past twenty years only because the industry was in its infancy.

In the past, software prices have continuously decreased in response to competition. Assuming that this trend continues, software companies will eventually be forced to give away their software for free. Once this happens, companies which use a PO model will be required to start using an SO model. For example, the pressures felt by Oracle from MySQL, which was mentioned earlier in this report, are cause by Oracle licensing fees. Since Oracle has better features and a greater market share than MySQL, it could be possible for Oracle to eliminate the threat caused by MySQL by changing their business model to an SO model; that is, to provide Oracle for free to its customer base. I also believe that Oracle will have to do this in order to survive in the future.

An interesting aspect of the Peruvian open source bill, cited earlier in this report, is that the government officials felt that the bill was needed. A Peruvian congressman stated two reasons for this in an open letter. The first is that the Peruvian government believes that the general public must be able to access all public information. Proprietary software does not allow this to occur, since it traditionally stores information in its own formats, which are not publicly open. The second reason for the bill is the fear that since each of the public department functions as an independent unit, it would be possible for some of these departments to accidentally purchase proprietary software, and hence inhibit the public access to their data[13].

Further research should analyze the current educational programs for IS professionals. I think that a great deal of resources are currently being used to train future knowledge workers without giving them proper humanistic skills. I believe that this will be a serious handicap for workers in an SO model.

Recommendations

Software specialists wanting to stay in the IS industry need to adapt to changes in business model. The SO business model requires professionals who are capable of learning new technologies quickly, and are able to adapt and function in an environment which is continuously evolving. Furthermore, the SO model does not generate the same level of ROI as the PO model. Because of this, compensations paid to software developers in developed countries will decrease as the model changes.

As the software industry matures, opportunities for using the PO model will still be present. However, these opportunities will only be available for a short period of time, as competitors quickly form after new niches are created. Companies should calculate the rate at which they can convert from a PO to an SO model to maximize their profits. For instance, to evade competition, or to fully establish themselves as the global platform, Microsoft may want to offer its Windows product free of charge. This would be the same strategy that it used when it started offering its Internet Explorer product free of charge.

Software companies should focus on creating software teams that are employable in an SO model. Although such teams will need to have technological prowess, soft skills such as teamwork and communication also need to be valued.